Bernanke and Yellen have long warned of the drawbacks of too much deficit reduction. (Alex Wong/Getty Images)

January 10, 2014

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After the financial crisis of 2008, many countries faced deep recessions, soaring unemployment and massive private debt overhangs. Some countries — like the United States — responded with stimulus programs, pushing more money out into the economy in a bid to create jobs and put money in people's pockets.

Other countries assumed that too much government borrowing would lead to rising interest rates. Furthermore, they fretted that racking up debt now would inevitably lead to higher taxes in the future to pay off that debt; so better to nip that problem in the bud, which would theoretically inject confidence — that magical, unquantifiable ingredient — into the economy.

But contrary to what folksy politicians would have you believe, balancing a government budget isn't like trying to balance a household budget. It's not simply a matter of calculating money in and money out, because when the government cuts (or increases) spending it also cuts (or increases) the income of lots of people in the economy.

So what's going on here? Well the deficit is the sum of two things — spending and tax receipts. If spending is cut, the deficit will still increase if tax receipts fall by a larger amount. And cutting spending can itself cut tax receipts by lowering the income of consumers, which hurts their spending power, which in turn hurts businesses, which in turn lowers their profits, which in turn leads to decreased tax revenue for the government.

A more extreme example is Greece, which has been trying to fight its deficit since 2008. Unlike Britain and the U.S., Greece is part of the euro zone, meaning that its government does not borrow in its own currency, which creates the risk of not having enough money to pay off its debts. Because of this, Greece has been forced to cut its spending far more deeply than Britain, a policy which has come at the cost of over 25 percent unemployment and a massive downturn in the size of the economy.

In other words, a weak market with falling tax receipts can force the government to push more money out into the economy than it takes in —even while the government is cutting spending like mad to fight the deficit. This is the market forcing the government into deficit spending.